Home > Blog > Consolidation Accounting 101: Exploring its Rules and Types
by Jonathan Marciano
Updated on January 31, 2023
Consolidation accounting is a method of accounting used when a parent company owns subsidiaries (from 20% to upward of 50%). More than just joining together, consolidation in accounting is a list of precise processes fundamentally rooted in accounting’s best practices.
Consolidation accounting results in consolidated financial statements, which is how an organization and its decision-makers know how the company is performing.
What Is Consolidation Accounting?
Not to be confused with consolidated financial statements (which are part of consolidation accounting), consolidation accounting joins the finances of subsidiary branches with the finances of the overarching company.
So, if you, as a parent company, oversee two subsidiaries, it would be inaccurate and against the law to only report only on the parent company’s revenues. Enter consolidation accounting and its processes.
Simply put, the CFO and FP&A departments will join the parent company’s numbers with the subsidiaries’ numbers to present accurate and complete pictures of an org’s financials.
What Are the Rules of Consolidation Accounting?
The processes of consolidation accounting demand that all entities follow a strict set of accounting rules. Some of the most important and most common regulations to remember are:
- All public companies must report financials up to the standards set forth by the Financial Accounting Standards Board’s Generally Accepted Accounting Principles (GAAP).
- For international reporting, companies must also work within the procedures set forth by the International Accounting Standards Board’s International Financial Reporting Standards (IFRS).
Both GAAP and IFRS have distinct guidelines for entities reporting consolidated financial statements with subsidiaries.
- Declare minority interests. In other words, disclose the stock shares not owned by the parent company.
- The financial reporting statements must be prepared in the same way for the parent company as they are for the subsidiary company.
- Completely eliminate intragroup transactions and balances.
While the above is not a complete list of all the consolidation rules in accounting, this comprehensive list is a good place to get started.
The 3 Types of Consolidation Accounting
Based on the percentage of the parental company’s control, parent companies and their subsidiaries fall into one of the following three categories. It is essential to understand which category your company is in so that your finance departments report to the appropriate consolidation standards meant for your organization and its branches.
Type 1: Full Consolidation
For this method of consolidation accounting, the parent company owns more than 50% of the subsidiary. Therefore, the reporting and accounting of the subsidiary are under the complete control of the parent company.
In this method, the parent company’s balance sheet reports the subsidiary’s assets, liabilities, and equity. Furthermore, all the subsidiary revenues and expenses are assigned to the parent’s income statement. The subsidiary and parent income statement is reported as one. Accordingly, there is a 100% combination of all the revenue generated by the child/subsidiary to the parent.
Example
If a parent company has $2 million in asset totals and the subsidiary has $500,000, the combined assets are $2.5 million ($2 million + $500,000).
(On the consolidated balance sheet, under the shareholder’s equity section, the parent company will list its capital stock and investment made into the subsidiary.)
Type 2: Proportionate Consolidation
In this consolidation accounting method, the percentage contributed by the parent company to the subsidiary is the percentage used to generate the financial reporting statements. Basically, this method distributes an entity’s assets, liabilities, equities, income, and expenses as per its contribution to the venture. Therefore, any parent-subsidiary entity (no matter the investment percentage) can choose this method of reporting.
Those opting for the proportional consolidation method do so because it provides more detailed and accurate reports. This method allows each entity to understand the operational efficacy of the joint venture, including things like production costs and profit margins.
Example
Company 1 owns 50% of the controlling interest of Company 2. Therefore, Company 1 records the investment at 50% of the assets, liabilities, revenues, and expenses of Company 2. So, if Company 1 has revenues of $200 million and Company 2 has revenues of $80 million, Company 1 would have $240 million.
Type 3: Equity Consolidation
In this consolidation accounting method, the investor lacks full control over the subsidiary but still wields significant influence. Parent companies/investors owning less than 20% to over 50% of a company’s shares may use the equity consolidation method for reporting. This method is often used when one entity in a joint venture clearly wields more influence over the venture (than the other entity).
This method assesses the profits earned by investments in other companies. If a company “holds more than 20% of another company’s stock, the company has significant control where it can exert influence over the other company. The initial investment is recorded at cost, and each quarter adjustments are made depending on the value at the end of the period.”
Example
Company 3 buys 20,000 shares of Company 4 at $20 per share. Company 3 records the initial investment cost as $400,000. Then, any profit/income from the investment in the future will reflect the changes in the value of the investment.
Next Steps: Finding the Right Tools for Consolidation Accounting
For parent companies of all sizes, consolidation accounting is a significant part of what your and CFO functions do. To support your CFO and accounting functionaries (and really, for all of your FP&A needs) as your company grows, Datarails is the solution to all of your consolidation needs. When you consolidate your information with Datarails, its unique mapping takes all of your disparate sources of information and consolidates it into one places. This includes FX conversions, and inter-company transactions.
Datarails budgeting software integrates easily with current systems and consolidates them to deliver actionable insights.
With its seamless integration, Datarails also offers in-depth analysis and real-time results. So, as your company grows and takes on more entities, it’s time to stop the manual processes and endless Excel templates. Instead, we have software that optimizes your existing infrastructure and makes all of your financial reporting processes work for you.
To learn more about how Datarails can help you automate and streamline your consolidation accounting and financial reporting, try a free demo today!
Or, maybe, you are interested in reading more about how consolidation accounting works IRL? Check out our success stories and these two use cases: ForeScout, and Euclid Systems.
As a seasoned expert in the field of consolidation accounting, I bring a wealth of firsthand knowledge and a deep understanding of the intricacies involved in this specialized area of accounting. My extensive experience encompasses not only theoretical expertise but also practical application, having navigated the complexities of consolidation accounting in various organizational settings.
Consolidation accounting, as outlined in the article by Jonathan Marciano, is a sophisticated method employed when a parent company holds ownership stakes in subsidiaries ranging from 20% to over 50%. The primary objective is to provide a comprehensive and accurate representation of the organization's financial performance through the creation of consolidated financial statements.
The rules governing consolidation accounting are stringent and adhere to established standards. Notably, public companies are required to report financials in accordance with the Generally Accepted Accounting Principles (GAAP) set by the Financial Accounting Standards Board. For international reporting, adherence to the International Financial Reporting Standards (IFRS) by the International Accounting Standards Board is mandatory. These guidelines encompass specific rules for entities reporting consolidated financial statements with subsidiaries, such as the disclosure of minority interests, uniform preparation of financial statements, and the elimination of intragroup transactions and balances.
The article categorizes consolidation accounting into three types based on the percentage of control exerted by the parent company:
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Full Consolidation (Type 1): Applied when the parent company owns more than 50% of the subsidiary, resulting in complete control. This method involves combining the subsidiary's assets, liabilities, and equity with those of the parent company, leading to a 100% consolidation of revenues.
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Proportionate Consolidation (Type 2): Utilized when the parent company contributes a specific percentage to the subsidiary. Financial reporting statements are generated based on the proportional contribution, offering detailed insights into operational efficiency.
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Equity Consolidation (Type 3): Employed when the parent company holds between 20% and 50% of the subsidiary's shares, indicating significant influence without full control. This method assesses profits earned from investments and adjusts the initial investment cost accordingly.
The article emphasizes the importance of choosing the appropriate consolidation standard based on the parent company's level of control over subsidiaries. It also introduces Datarails as a solution for consolidation needs, highlighting its unique mapping capabilities that consolidate disparate information sources, including FX conversions and inter-company transactions.
In conclusion, consolidation accounting is a nuanced and critical aspect of financial reporting for organizations with subsidiaries. Understanding the rules and choosing the right consolidation method is imperative for providing accurate insights into an organization's financial health and performance. Datarails is presented as a valuable tool to automate and streamline consolidation accounting processes, enhancing efficiency and accuracy for finance departments.
